Keen Household Debt -1- Australian Economic Review

Household Debt—the final stage in an artificially
extended Ponzi Bubble
Steve Keen, University of Western Sydney, s.keen@uws.edu.au,
www.debtdeflation.com/blogs
1. The Macroeconomics of Private Debt
Private debt is largely ignored by conventional macroeconomics. It is a key issue in the
non-orthodox ‘Minskian’ approach to economics, which rejects the standard ‘veil over
barter’ attitude towards money (Minsky (1982a)). Ironically, though Friedman
championed ‘money neutrality’, unintended support for Minsky’s ‘money matters’
position can be found in Friedman. His well-known assertion that the nominal quantity of
money was irrelevant contained an important but neglected proviso, highlighted below:
IT IS A COMMONPLACE of monetary theory that nothing is so
unimportant as the quantity of money expressed in terms of the nominal
monetary unit… let the number of dollars in existence be multiplied by
100; that, too, will have no other essential effect, provided that all other
nominal magnitudes (prices of goods and services, and quantities of other
assets and liabilities that are expressed in nominal terms) are also
multiplied by 100. Friedman (1969 , p. 1; Emphasis added)
In the real world in which we live, assets and liabilities are not indexed to the rate of
inflation.
1
Nominal magnitudes therefore do matter in macroeconomics, because they
determine our capability to service past financial commitments out of current cash flows.
My Minskian focus upon debt is the reason I was able to anticipate a serious financial
crisis (Keen (1995), (1996),
2
(2000), (2007)) while leading neoclassical macroeconomists
were busy debating the causes of the now defunct ‘Great Moderation’ (Bernanke (2004)).
The impact that private debt has on the economy is affected by its scale relative to GDP,
its composition, purpose, and rate of change. On all four fronts, our current debt crisis is
more severe than that which caused the Great Depression (Fisher (1933)).
2. Magnitude, Composition and Purpose
In late 1990, Australia’s private debt to GDP ratio peaked at 85 per cent. It then fell to 79
per cent in mid-1993, only to more than double to a peak of 165 per cent in March 2008.
This literally exponential rise in the debt ratio masked an important change in its
composition. The business ratio fell sharply between late 1990 and 1995, and only
returned to 1990 levels in 2006. The household ratio, on the other hand, rose at 6.6 per
cent per annum between 1990 and March 2008, while the mortgage ratio rose at 8.5 per
cent per annum.
3
This took household debt from 30 to 99 per cent of GDP—and
mortgage debt from 20 per cent to 85 per cent—in just over 18 years.
FIGURE 1 ABOUT HERE: Australian Debt to GDP Ratios
Keen Household Debt -2- Australian Economic Review
1960 1970 1980 1990 2000 2010
0
20
40
60
80
100
0
40
80
120
160
200
Household
Business
Government
Total Private (RHS)
RBA Bulletin Tables D02 & G12
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Though the US household debt binge has grabbed the headlines, ours was actually more
dramatic. America’s ratio was twice Australia’s in 1990, but grew much more slowly—a
mere 2.3 per cent per annum from 1990 till its peak of 98 per cent in 2008. Though
lending here may not have been as irresponsible at the individual level as in America, the
aggregate effect has been the same: Australian households, like their American
counterparts, have a higher ratio of debt to income than ever before.
FIGURE 2 ABOUT HERE: Australian vs US Household Debt to GDP Ratios
Keen Household Debt -3- Australian Economic Review
1985 1990 1995 2000 2005 2010
0
20
40
60
80
100
USA
Australia
Mortgage Debt Only
RBA Bulletin; FRB Flow of Funds ltab1d, atab6d
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Attempts to explain increasing debt as merely an equilibrium response to falling interest
rates do not withstand scrutiny. RBA Governor Stevens put this proposition to the
Parliamentary Standing Committee on Economics and Finance in 2007, in answering
whether ‘cheaply available credit’ had influenced asset prices:
The rough statistic that I have quoted many times was that the average rate
of interest was about half; that meant you could service twice as big a
debt. Guess what? That is exactly what occurred, and that had a very
profound effect on asset values. Standing Committee On Economics
(2007, p. 26)
If this were true, then interest payments to GDP would have remained roughly constant
as interest rates fell, rose and fell again over 1990-2008. At the aggregate level and at the
two extremes—1990, when the average interest rate was almost 20 per cent, and 2008,
when ‘Peak Debt’ occurred—this statement appears approximately correct. However
over time the debt service ratio was not constant, but fell substantially as interest rates
also fell, only to rise back to 1990 levels by 2008.
The aggregate data also masked the substantial changes in the composition of debt over
time: though the aggregate ratio did roughly double, business debt increased a mere 22
per cent (after having fallen as much as 25 per cent) while household debt more than
tripled.
FIGURE 3 ABOUT HERE: Private Debt Service Ratio and Interest Rates
Keen Household Debt -4- Australian Economic Review
1990 1995 2000 2005 2010
5
10
15
20
Payments % GDP
Average Interest Rate
Source: RBA Bulletin
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As in 1990, the 2008 debt service level was not an equilibrium, but rather a maximum at
which debt service costs caused a sudden swing from prosperity to a severe economic
downturn.
Though the argument that the rise in debt was an equilibrium response to falling interest
rates is false, the proposition that it drove asset prices is defensible. Again, though the US
house price bubble has grabbed the headlines, on any measure the Australian bubble has
been bigger. Without adjusting for differences in base years, the peak in the Australian
real house price index was 20 per cent higher than the peak in the American index. When
adjusted to the same base year using data from Stapledon (2007, Table 2.5, pp. 64-65),
the Australian index was a mere 8 per cent higher than the American in 1987, but rose to
be 81 per cent higher than the American peak.
FIGURE 4 ABOUT HERE: Real House Price Indices
Keen Household Debt -5- Australian Economic Review
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
0
50
100
150
200
250
300
350
400
Australia (Base June 1986)
Australia (Base 1890)
USA (Base 1890)
Stapledon, ABS 6416, Case-Shiller
I
n
d
e
x
B
a
s
e
=
1
0
0
Speculation, rather than investment, was overwhelming the focus of post-1990 lending.
The primary role of mortgage debt was to purchase existing dwellings rather than to
finance the construction of new ones: in 1985, less than 25 per cent of new mortgage
finance was for new dwellings; by 2000 this had fallen below 10 per cent. 85 per cent of
the additional A$985 billion of mortgage debt accumulated since 1986 has therefore
predominantly inflated house prices, rather than built new homes. Margin lending—
which rose from $4.7 billion to $37.75 billion between late 1999 and 2008—was clearly
for speculative purposes only. Since a substantial proportion of recent business debt also
financed speculative activity—leveraged buyouts, mergers and acquisitions and the
like—over half of Australia’s $1.9 trillion private debt financed speculation rather than
investment.
3. Rate of Change
The rate of change of debt and its magnitude relative to GDP determine the contribution
that changes in debt make to aggregate demand, which in our credit-driven world is the
sum of GDP plus the change in debt. This demand is clearly spread across all markets,
commodity and assets alike, so that where a change in debt-financed demand will fall
cannot be determined a priori—but that impact is now substantial. Before 1970, the
change in private debt was responsible for less than 5 per cent of aggregate demand.
Since 1980, it has been responsible for up to 20 per cent of demand, and it has become
the dominant factor in determining the level of unemployment. In our debt-dependent
economy, rising debt reduces unemployment, while falling debt increases it.
FIGURE 5 ABOUT HERE: Debt Contribution to Demand and Unemployment
Keen Household Debt -6- Australian Economic Review
1960 1970 1980 1990 2000 2010
10 ÷
5 ÷
0
5
10
15
20
25 0
12
10
8
6
4
2
0
Debt Contribution
Unemployment (RHS)
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d
)
This is the third and by far the largest debt bubble in Australia’s economic history. Just as
the bursting of the two earlier debt bubbles ushered in Depressions, I expect the same will
result from the bursting of this bubble, and for the same reason. De-leveraging by the
private sector will significantly reduce aggregate demand, and cause a consequent severe
reduction in economic activity and employment.
FIGURE 6 ABOUT HERE: Australian Long Term Debt to GDP Ratios
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
0
40
80
120
160
200
Private Debt Ratio
1880-92 Bubble
1925-32 Bubble
1964-2008 Bubble
Household Debt
Business Debt
Battellino 2007; Fisher & Kent 1999; RBA Bulletin
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Keen Household Debt -7- Australian Economic Review
4. Drivers of the bubble—lenders or borrowers?
Though focusing on aggregate debt alone from 1993 till now obscures the important
recent role of rising household debt, over the much longer term the aggregate ratio
illustrates that the ultimate responsibility for debt bubbles lies not with the irrational
exuberance of borrowers, but the credit-creation practices of lenders (Battellino (2007,
Graph 3, p. 15); Fisher and Kent (1999, Figure 4, p. 7 & Figure 5, p. 9)).
At the aggregate level, the debt bubble can be dated back till mid-1964, when a 20-year
period of a stable debt ratio gave way to 44 years in which private debt grew 4.2 per cent
faster than nominal GDP. The correlation of the private debt ratio with a simple
exponential function is both extraordinarily high, and higher over the period 1964-2008
than the correlation of either disaggregated series over the shorter time period for which
data is available (see Table 1 and Keen (2009)).
Table 1: Growth Rates of Private Debt to GDP Ratios
Ratio to GDP Time Period Growth Rate Exponential
Correlation
Aggregate June 1964-March
2008
4.2% 0.991
Business September 1976-
March 2008
3.09% 0.769
Household September 1976-
March 2008
5.16% 0.985
5. Modelling the Dynamics of Speculative Finance
In Keen (2009) I constructed a model of endogenous money creation that is consistent
with the empirical data on money dynamics—which contradicts the standard ‘money
multiplier’ model of credit money creation (see Kydland and Prescott (1990), Moore
(1979) and (1983)). The model explained both the tendency of financial system to
provide as much credit as businesses and households are willing to accept, and simulated
the impact of a credit crunch on economic activity.
Here I extend my model of Minsky’s ‘Financial Instability Hypothesis’ (FIH; Keen
(1995)) to include one aspect of Minsky’s hypothesis that I did not originally incorporate,
but which is clearly of vital importance in the actual dynamics of debt: borrowing to
finance not productive investment, but ‘Ponzi’ speculation on asset prices. As outlined
above, this was the overwhelming purpose of the growth in household debt since 1990.
Minsky's hypothesis considers an economy in historical time, starting at a time where the
economy is growing relatively stably, but firms and banks are conservative about debt
levels after a recent economic crisis. However, the combination of a relatively tranquil
economy and conservative investment behaviour means that most projects succeed.
Two things gradually become evident: ‘Existing debts are easily validated and units that
were heavily in debt prospered: it paid to lever’ (Minsky (1982a, p. 66)). As a result, both
Keen Household Debt -8- Australian Economic Review
firms and banks come to regard the previously accepted risk premium as excessive.
Investment projects are evaluated using less conservative estimates of prospective cash
flows, so that with these rising expectations go rising investment and asset prices. The
general decline in risk aversion thus sets off the growth in debt-financed investment,
which is the foundation both of the boom and its eventual collapse. In Minsky’s classic
phrase, ‘Stability—or tranquility—in a world with a cyclical past and capitalist financial
institutions is destabilizing’ (Minsky (1977, p. 66)).
The economy enters a phase which Minsky characterised as ‘the euphoric economy’,
where both lenders and borrowers believe that the future is assured, and therefore that
most investments will succeed. Asset prices are revalued upward as previous valuations
are perceived to be based on mistakenly conservative grounds. Financial institutions now
accept liability structures both for themselves and their customers ‘that, in a more sober
expectational climate, they would have rejected’ (Minsky (1982b, p. 55)).
Asset price inflation in the euphoric economy phase makes it possible to profit by trading
assets on a rising market, giving rise to a class of speculators Minsky calls ‘Ponzi
financiers’, after the once again well-known American swindler (Minsky (1982a, p.
101)). These speculators are willing to incur debts whose servicing costs exceed the cash
flows of the assets they buy, because they expect to be able to on-sell these assets at a
profit. However the rising interest servicing costs incurred in this period eventually force
speculative and non-speculative investors alike to sell capital assets to meet their debt
commitments, and the entry of additional sellers into the asset market pricks the
exponential rise in prices on which Ponzi financiers depend. The leading Ponzis go
bankrupt, bringing the euphoric economy to an abrupt end and ushering in another debt-
induced systemic crisis.
A comprehensive model of this process would include asset price dynamics as well as
debt.
4
However the essence of Ponzi speculation is that debt is taken on that does not add
to the economy’s productive capacity. This can easily be introduced into my Minsky
model (built as an extension to Goodwin’s growth cycle model Goodwin (1967)) via a
nonlinear Ponzi investment function that depends on the rate of economic growth, and
which is financed entirely by debt. The model structure is outlined in Table 2:
Table 2: Causal Links in Model
Element Equation Comments, Parameter and Initial
Values
Output
Y K v =
Capital stock and the accelerator
determines output. Y(0)=300, v=3
Capital Stock
( )
r
d
K I Y K
dt
t ¸ = · ÷ ·
The rate of change of capital stock is
investment minus depreciation. ¸=1%
Profit Y W r D H = ÷ ÷ · Profit is output minus wages and
interest payments. r=3%
Profit Rate
( )
r
K v Y t = H = H ·
Wage Bill W w L = · Wage bill is wages times labour
Keen Household Debt -9- Australian Economic Review
employed.
Wages
( )
1
C
d
w P
w dt
ì · =
A Phillips curve relation for wage
determination. w(0)=1
Employment
Rate
L N ì =
Labour
L Y a =
Output and labor productivity
determines employment.
Debt d
D I P
dt
K
= ÷H+
The rate of change of debt equals
investment minus profits plus
speculation. D(0)=0
Speculation
( )
d
P g Y
dt
k
K
= ·
The rate of change of Ponzi speculation
is a nonlinear function of the rate of
growth. P
K
(0)=0
Rate of
growth
( ) ( )
r
g I v t ¸ = ÷
Investment
( ) ( ) , 3%, 3%,1, 0
r Exp r
I G t t =
Investment is a nonlinear function of
the rate of profit.
Phillips curve
( ) ( ) , 96%, 0, 2, 4%
C Exp
P G ì ì = ÷
Wage change is a nonlinear function of
the rate of employment.
Ponzi
behaviour
( ) ( ) , 3%, 0, 3, 25%
Exp
g G g k = ÷
Speculation is a nonlinear function of
the rate of growth.
Generalised
Exponential
( )
( )
( )
, , , ,
v
v
Exp v v
s
x x
y m
v
G x x y s m
y m e m
· ÷
÷
=
÷ · +
Generalised exponential. Arguments
(x
v
,y
v
) coordinates, slope at (x
v
,y
v
) and
minimum value m.
Population d
N N
dt
| = ·
|=1%, N(0)=330
Labour
Productivity
d
a a
dt
o = ·
o=2%, a(0)=1
This reduces to a model with 6 system states:
Keen Household Debt -10- Australian Economic Review
( )
( )
( )
C
r
d
Y g Y
dt
d
w P w
dt
d
D I Y P
dt
d
P g Y
dt
d
a a
dt
d
N N
dt
ì
t
k
o
|
K
K
= ·
= ·
= · ÷H+
= ·
= ·
= ·
(1.1)
Without Ponzi finance, the model can generate a debt crisis given extreme initial
conditions, but near its equilibrium the model is stable (the equilibrium debt ratio is
negative—see Keen (2000)—implying a net positive financial position for firms). With
Ponzi finance however, the system undergoes a series of boom/bust cycles with debt
levels ratcheting up over time, until ultimately the debt incurred in the final cycle
overwhelms the economy’s debt-servicing capacity, and a Depression ensues.
FIGURE 7 ABOUT HERE: Output
0 10 20 30 40 50
0
500
1000
1500
No Speculation
Ponzi Finance
Real Output
The presence of Ponzi Finance also leads to bigger cycles in output with a longer period.
Though the average rate of growth prior to the crisis is similar to that achieved without
Keen Household Debt -11- Australian Economic Review
Ponzi lending, volatility is far greater, but the rise in volatility is somewhat masked by
the increase in the period between downturns.
FIGURE 8 ABOUT HERE: Employment
0 10 20 30 40 50
70
80
90
100
No Speculation
Ponzi Finance
Employment Rate
Years
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FIGURE 9 ABOUT HERE: Employment and Income Distribution
Keen Household Debt -12- Australian Economic Review
70 80 90 100
40
60
80
100
120
No Speculation
Ponzi Finance
Employment & Income Distribution
Employment Rate per cent
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FIGURE 10 ABOUT HERE: Debt to GDP
0 10 20 30 40 50
120 ÷
100 ÷
80 ÷
60 ÷
40 ÷
20 ÷
0
20
200 ÷
0
200
400
600
800
1000
1200
No Speculation (LHS)
Ponzi Finance (RHS)
Debt to GDP Ratio
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A far higher level of debt is accumulated with Ponzi lending than without, and that debt
level ultimately causes not merely a cyclical downturn but a complete economic collapse.
Though this model has yet to be fitted to the actual data, its qualitative behaviour matches
the pattern that has led to the Global Financial Crisis.
Keen Household Debt -13- Australian Economic Review
6. Conclusion
Had the Federal Reserve not intervened to rescue Wall Street from its excesses in 1987,
there could have been a mild Depression back then. Debt levels were comparable to
1929: 159 per cent of GDP in the USA versus 173 per cent in 1929, and 73 per cent in
Australia versus 64 per cent. Debt-financed demand was a much smaller fraction of
aggregate demand—13 per cent in the USA, under 10 per cent in Australia—so that
deleveraging would have occurred from a much lower base than today’s.
Inflation was also higher—4.5 per cent in the USA versus zero in 1929, and 7.8 per cent
in Australia versus 2 per cent—so that the debt burden would have been reduced by
nominal factors. Finally, most of the debt was owed by businesses—who can more easily
eliminate it than can households (via reducing employment, terminating investment, and
bankruptcy)—and the scourges of derivatives and securitised lending had only just
begun.
By forestalling a Depression then, we may have been set up for a far more serious
problem now. Today, US debt is 1.7 times as high as in 1929, and deflation is already
running at 0.75 per cent. Australia’s debt ratio is 2.5 times what it was in 1929, and while
we have not yet fallen into deflation, inflation is less than half the 1987 level. Debt-
financed demand accounted for 23 per cent of aggregate demand at its peak in the USA,
and 20 per cent here, so deleveraging today could swamp government attempts to reflate
the economy. Households hold more debt than business, and ownership of that debt has
been dispersed through society via securitised lending.
Bernanke famously apologised to Friedman on behalf of the 1929 Fed, stating that
‘Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to
you, we won’t do it again.’ (Bernanke (2002)). In fact, thanks to Friedman’s flawed
theory of money, the Greenspan-Bernanke Fed may one day justly stand accused of
having caused a far greater crisis than that of 1929.
Battellino, R. 2007, 'Some Observations On Financial Trends', Reserve Bank of Australia
Bulletin, vol. 2007, no. October, pp 14-21.
Bernanke, B. S. 2002, 'Remarks by Governor Ben S. Bernanke', paper presented to
Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois,
November 8, 2002.
Bernanke, B. S. 2004, 'The Great Moderation: Remarks by Governor Ben S. Bernanke At
the meetings of the Eastern Economic Association, Washington, DC February 20,
2004', paper presented to Eastern Economic Association, Washington, DC.
Fisher, C. and Kent, C. 1999, 'Two Depressions, One Banking Collapse', in Reserve Bank
of Australia Research Discussion Papers, vol. 1999, Reserve Bank of Australia,
Sydney, NSW, Australia.
Fisher, I. 1933, 'The Debt-Deflation Theory of Great Depressions', Econometrica, vol. 1,
no. 4, pp 337-357.
Friedman, M. 1969, 'The Optimum Quantity of Money', in The Optimum Quantity of
Money and Other Essays, MacMillan, Chicago.
Goodwin, R. 1967, 'A growth cycle', in Socialism, Capitalism and Economic Growth, ed
C. H. Feinstein, Cambridge University Press, Cambridge.
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Keen, S. 1995, 'Finance and Economic Breakdown: Modeling Minsky's 'Financial
Instability Hypothesis.'', Journal of Post Keynesian Economics, vol. 17, no. 4, pp
607-635.
Keen, S. 1996, 'Supplementary Remarks to the Wallis Committee', ed A. T. Wallis
Committee, Canberra.
Keen, S. 2000, 'The Nonlinear Economics of Debt Deflation', in Commerce, complexity,
and evolution: Topics in economics, finance, marketing, and management:
Proceedings of the Twelfth International Symposium in Economic Theory and
Econometrics, ed W. A. Barnett, Cambridge; New York and Melbourne:
Cambridge University Press.
Keen, S. 2007, 'Deeper in Debt: Australia's addiction to borrowed money', in Occasional
Papers, Centre for Policy Development.
Keen, S. 2009, 'Bailing out the Titanic with a Thimble', Economic Analysis & Policy, vol.
39, no. 1, pp 3-24.
Kydland, F. E. and Prescott, E. C. 1990, 'Business Cycles: Real Facts and a Monetary
Myth', Federal Reserve Bank of Minneapolis Quarterly Review, vol. 14, no. 2, pp
3-18.
Minsky, H. P. 1977, 'The Financial Instability Hypothesis: An Interpretation of Keynes
and an Alternative to 'Standard' Theory', Nebraska Journal of Economics and
Business, vol. 16, no. 1, pp 5-16.
Minsky, H. P. 1982a, Can "it" happen again? : essays on instability and finance, M.E.
Sharpe, Armonk, N.Y.
Minsky, H. P. 1982b, Inflation, Recession and Economic Policy, Wheatsheaf, Sussex.
Moore, B. J. 1979, 'The Endogenous Money Stock', Journal of Post Keynesian
Economics, vol. 2, no. 1, pp 49-70.
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Money Supply', Journal of Post Keynesian Economics, vol. 5, no. 4, pp 537-556.
Standing Committee On Economics, F. A. P. A. 2007, 'Reference: Reserve Bank of
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Perspectives', PhD, School of Economics, University of New South Wales.
1
Except in Iceland, where debts (but not other nominal magnitudes such as wages) were indexed to the rate
of inflation, with disastrous results.
2
In my supplementary remarks to the Wallis Committee Inquiry in 1996, I anticipated that a financial crisis
could result from the practice of securitised lending: “Should a substantial proportion of eligible assets
(e.g., residential houses during a real estate boom like that of 87-89) be financed by securitised instruments,
the inability of borrowers to pay their debts on a large scale will not, of course, directly affect liquidity in
the same fashion that a failure of bank debtors does. Instead, the impact will be felt by those who purchased
the securities ...Where the securities are tradeable, there would obviously be a collapse in the tradeable
price, and, potentially, the bankrupting of many of the investors...”
3
The correlation coefficient of the total private debt ratio between mid-1993 and March 2008 to a simple
exponential function with a growth rate of 4.6% is 0.9966; the coefficient for the household debt ratio
between 1990 and March 2008 with a growth rate of 6.05% was 0.9969.
Keen Household Debt -15- Australian Economic Review
4
In future research I will combine this model and that in Keen 2009 into a strictly monetary model of the
FIH.

100 200 80 Household Business Government Total Private (RHS) 160 Per cent of GDP 60 120 40 80 20 40 0 1960 1970 1980 1990 2000 0 2010 RBA Bulletin Tables D02 & G12 Though the US household debt binge has grabbed the headlines. ours was actually more dramatic. the aggregate effect has been the same: Australian households. America’s ratio was twice Australia’s in 1990. like their American counterparts. FIGURE 2 ABOUT HERE: Australian vs US Household Debt to GDP Ratios Keen Household Debt -2- Australian Economic Review Per cent of GDP . have a higher ratio of debt to income than ever before. but grew much more slowly—a mere 2.3 per cent per annum from 1990 till its peak of 98 per cent in 2008. Though lending here may not have been as irresponsible at the individual level as in America.

RBA Governor Stevens put this proposition to the Parliamentary Standing Committee on Economics and Finance in 2007. when ‘Peak Debt’ occurred—this statement appears approximately correct. in answering whether ‘cheaply available credit’ had influenced asset prices: The rough statistic that I have quoted many times was that the average rate of interest was about half. 26) If this were true. and that had a very profound effect on asset values. At the aggregate level and at the two extremes—1990. atab6d Attempts to explain increasing debt as merely an equilibrium response to falling interest rates do not withstand scrutiny. The aggregate data also masked the substantial changes in the composition of debt over time: though the aggregate ratio did roughly double. only to rise back to 1990 levels by 2008. Standing Committee On Economics (2007.100 80 USA Australia Mortgage Debt Only Per cent of GDP 60 40 20 0 1985 1990 1995 2000 2005 2010 RBA Bulletin. that meant you could service twice as big a debt. p. then interest payments to GDP would have remained roughly constant as interest rates fell. rose and fell again over 1990-2008. FIGURE 3 ABOUT HERE: Private Debt Service Ratio and Interest Rates Keen Household Debt -3- Australian Economic Review . FRB Flow of Funds ltab1d. However over time the debt service ratio was not constant. when the average interest rate was almost 20 per cent. but fell substantially as interest rates also fell. business debt increased a mere 22 per cent (after having fallen as much as 25 per cent) while household debt more than tripled. and 2008. Guess what? That is exactly what occurred.

Without adjusting for differences in base years. Though the argument that the rise in debt was an equilibrium response to falling interest rates is false. Again. FIGURE 4 ABOUT HERE: Real House Price Indices Keen Household Debt -4- Australian Economic Review . though the US house price bubble has grabbed the headlines. on any measure the Australian bubble has been bigger. the peak in the Australian real house price index was 20 per cent higher than the peak in the American index.5. the Australian index was a mere 8 per cent higher than the American in 1987. When adjusted to the same base year using data from Stapledon (2007. 64-65). the proposition that it drove asset prices is defensible. Table 2.20 Payments % GDP Average Interest Rate 15 Per cent 10 5 1990 1995 2000 2005 2010 Source: RBA Bulletin As in 1990. the 2008 debt service level was not an equilibrium. but rose to be 81 per cent higher than the American peak. but rather a maximum at which debt service costs caused a sudden swing from prosperity to a severe economic downturn. pp.

400 350 300 Australia (Base June 1986) Australia (Base 1890) USA (Base 1890) Index Base=100 250 200 150 100 50 0 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Stapledon.9 trillion private debt financed speculation rather than investment. In our debt-dependent economy. it has been responsible for up to 20 per cent of demand. while falling debt increases it. which in our credit-driven world is the sum of GDP plus the change in debt.75 billion between late 1999 and 2008—was clearly for speculative purposes only. Rate of Change The rate of change of debt and its magnitude relative to GDP determine the contribution that changes in debt make to aggregate demand. Case-Shiller Speculation. Since 1980. 3. so that where a change in debt-financed demand will fall cannot be determined a priori—but that impact is now substantial. commodity and assets alike. and it has become the dominant factor in determining the level of unemployment.7 billion to $37. by 2000 this had fallen below 10 per cent. was overwhelming the focus of post-1990 lending. FIGURE 5 ABOUT HERE: Debt Contribution to Demand and Unemployment Keen Household Debt -5- Australian Economic Review . the change in private debt was responsible for less than 5 per cent of aggregate demand. Before 1970. ABS 6416. mergers and acquisitions and the like—over half of Australia’s $1. The primary role of mortgage debt was to purchase existing dwellings rather than to finance the construction of new ones: in 1985. rather than investment. Margin lending— which rose from $4. Since a substantial proportion of recent business debt also financed speculative activity—leveraged buyouts. 85 per cent of the additional A$985 billion of mortgage debt accumulated since 1986 has therefore predominantly inflated house prices. less than 25 per cent of new mortgage finance was for new dwellings. rather than built new homes. This demand is clearly spread across all markets. rising debt reduces unemployment.

Fisher & Kent 1999. I expect the same will result from the bursting of this bubble.25 0 2 4 6 8 10 Per cent of Aggregate Demand 20 15 10 5 0 5  10 1960 Debt Contribution Unemployment (RHS) 1970 1980 1990 2000 12 2010 This is the third and by far the largest debt bubble in Australia’s economic history. FIGURE 6 ABOUT HERE: Australian Long Term Debt to GDP Ratios 200 160 Per cent of GDP Private Debt Ratio 1880-92 Bubble 1925-32 Bubble 1964-2008 Bubble Household Debt Business Debt 120 80 40 0 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Battellino 2007. RBA Bulletin Keen Household Debt -6- Australian Economic Review Per cent (inverted) . and for the same reason. De-leveraging by the private sector will significantly reduce aggregate demand. Just as the bursting of the two earlier debt bubbles ushered in Depressions. and cause a consequent severe reduction in economic activity and employment.

both Keen Household Debt -7Australian Economic Review .4. Figure 4. Modelling the Dynamics of Speculative Finance In Keen (2009) I constructed a model of endogenous money creation that is consistent with the empirical data on money dynamics—which contradicts the standard ‘money multiplier’ model of credit money creation (see Kydland and Prescott (1990). Keen (1995)) to include one aspect of Minsky’s hypothesis that I did not originally incorporate. when a 20-year period of a stable debt ratio gave way to 44 years in which private debt grew 4. As outlined above. 66)). Drivers of the bubble—lenders or borrowers? Though focusing on aggregate debt alone from 1993 till now obscures the important recent role of rising household debt.16% Exponential Correlation 0. 9)). As a result. the debt bubble can be dated back till mid-1964.991 0. Table 1: Growth Rates of Private Debt to GDP Ratios Ratio to GDP Aggregate Business Household Time Period June 1964-March 2008 September 1976March 2008 September 1976March 2008 Growth Rate 4.09% 5.2 per cent faster than nominal GDP.2% 3. Moore (1979) and (1983)). but firms and banks are conservative about debt levels after a recent economic crisis. and higher over the period 1964-2008 than the correlation of either disaggregated series over the shorter time period for which data is available (see Table 1 and Keen (2009)). Here I extend my model of Minsky’s ‘Financial Instability Hypothesis’ (FIH. The model explained both the tendency of financial system to provide as much credit as businesses and households are willing to accept.769 0. At the aggregate level. However. but which is clearly of vital importance in the actual dynamics of debt: borrowing to finance not productive investment.985 5. The correlation of the private debt ratio with a simple exponential function is both extraordinarily high. 7 & Figure 5. p. this was the overwhelming purpose of the growth in household debt since 1990. Fisher and Kent (1999. but the credit-creation practices of lenders (Battellino (2007. p. Graph 3. and simulated the impact of a credit crunch on economic activity. but ‘Ponzi’ speculation on asset prices. the combination of a relatively tranquil economy and conservative investment behaviour means that most projects succeed. 15). over the much longer term the aggregate ratio illustrates that the ultimate responsibility for debt bubbles lies not with the irrational exuberance of borrowers. Minsky's hypothesis considers an economy in historical time. p. starting at a time where the economy is growing relatively stably. Two things gradually become evident: ‘Existing debts are easily validated and units that were heavily in debt prospered: it paid to lever’ (Minsky (1982a. p.

in a more sober expectational climate. The general decline in risk aversion thus sets off the growth in debt-financed investment.firms and banks come to regard the previously accepted risk premium as excessive. Asset prices are revalued upward as previous valuations are perceived to be based on mistakenly conservative grounds. where both lenders and borrowers believe that the future is assured. ‘Stability—or tranquility—in a world with a cyclical past and capitalist financial institutions is destabilizing’ (Minsky (1977. 101)). and which is financed entirely by debt. p. which is the foundation both of the boom and its eventual collapse. Investment projects are evaluated using less conservative estimates of prospective cash flows. so that with these rising expectations go rising investment and asset prices. Asset price inflation in the euphoric economy phase makes it possible to profit by trading assets on a rising market. However the rising interest servicing costs incurred in this period eventually force speculative and non-speculative investors alike to sell capital assets to meet their debt commitments. p. =1% Profit is output minus wages and interest payments. r=3% YK v d K  I  r   Y    K dt   Y W  r  D  r   K   v Y  W  w L Wage bill is wages times labour Keen Household Debt -8- Australian Economic Review . and therefore that most investments will succeed. The leading Ponzis go bankrupt. 55)). 66)). In Minsky’s classic phrase. giving rise to a class of speculators Minsky calls ‘Ponzi financiers’. The model structure is outlined in Table 2: Table 2: Causal Links in Model Element Output Capital Stock Profit Profit Rate Wage Bill Equation Comments. they would have rejected’ (Minsky (1982b. bringing the euphoric economy to an abrupt end and ushering in another debtinduced systemic crisis. A comprehensive model of this process would include asset price dynamics as well as debt. after the once again well-known American swindler (Minsky (1982a. These speculators are willing to incur debts whose servicing costs exceed the cash flows of the assets they buy. Parameter and Initial Values Capital stock and the accelerator determines output. because they expect to be able to on-sell these assets at a profit.4 However the essence of Ponzi speculation is that debt is taken on that does not add to the economy’s productive capacity. and the entry of additional sellers into the asset market pricks the exponential rise in prices on which Ponzi financiers depend. p. Financial institutions now accept liability structures both for themselves and their customers ‘that. This can easily be introduced into my Minsky model (built as an extension to Goodwin’s growth cycle model Goodwin (1967)) via a nonlinear Ponzi investment function that depends on the rate of economic growth. v=3 The rate of change of capital stock is investment minus depreciation. Y(0)=300. The economy enters a phase which Minsky characterised as ‘the euphoric economy’.

2. xv .96%. m    yv  m   e yv m Population Labour Productivity d N   N dt d a  a dt s  x  xv  m Generalised exponential. 0  Investment is a nonlinear function of the rate of profit.3%. slope at (xv. P(0)=0 Speculation Rate of growth Investment Phillips curve Ponzi behaviour Generalised Exponential g   I  r  v    I  r   GExp  r . The rate of change of debt equals investment minus profits plus speculation. =1%. GExp  x. s.   g   GExp  g . Wages Employment Rate Labour Debt 1 d  w  PC    w dt A Phillips curve relation for wage determination.yv) coordinates.3%. PC     GExp   . D(0)=0 The rate of change of Ponzi speculation is a nonlinear function of the rate of growth. a(0)=1 This reduces to a model with 6 system states: Keen Household Debt -9- Australian Economic Review .1. yv . 4%  Wage change is a nonlinear function of the rate of employment. 0.3. w(0)=1 L N L Y a d D  I    P dt d P    g   Y dt Output and labor productivity determines employment. 0. 25%  Speculation is a nonlinear function of the rate of growth. N(0)=330 =2%.employed. Arguments (xv.yv) and minimum value m.3%.

the model can generate a debt crisis given extreme initial conditions.d Y  g Y dt d w  PC     w dt d D  I  r   Y    P dt d P    g   Y dt d a  a dt d N   N dt (1. until ultimately the debt incurred in the final cycle overwhelms the economy’s debt-servicing capacity. and a Depression ensues. but near its equilibrium the model is stable (the equilibrium debt ratio is negative—see Keen (2000)—implying a net positive financial position for firms). Though the average rate of growth prior to the crisis is similar to that achieved without Keen Household Debt -10- Australian Economic Review . the system undergoes a series of boom/bust cycles with debt levels ratcheting up over time. FIGURE 7 ABOUT HERE: Output Real Output 1500 No Speculation Ponzi Finance 1000 500 0 0 10 20 30 40 50 The presence of Ponzi Finance also leads to bigger cycles in output with a longer period.1) Without Ponzi finance. With Ponzi finance however.

Ponzi lending. volatility is far greater. FIGURE 8 ABOUT HERE: Employment Employment Rate 100 Per cent 90 80 No Speculation Ponzi Finance 70 0 10 20 30 40 50 Years FIGURE 9 ABOUT HERE: Employment and Income Distribution Keen Household Debt -11- Australian Economic Review . but the rise in volatility is somewhat masked by the increase in the period between downturns.

Employment & Income Distribution 120 No Speculation Ponzi Finance Wages per cent of Output 100 80 60 40 70 80 90 100 Employment Rate per cent FIGURE 10 ABOUT HERE: Debt to GDP Debt to GDP Ratio 20 0  20  40  60  80  100  120 1200 No Speculation (LHS) Ponzi Finance (RHS) 1000 800 600 400 200 0  200 50 Per cent of GDP 0 10 20 30 40 A far higher level of debt is accumulated with Ponzi lending than without. and that debt level ultimately causes not merely a cyclical downturn but a complete economic collapse. Though this model has yet to be fitted to the actual data. Keen Household Debt -12- Australian Economic Review Per cent of GDP . its qualitative behaviour matches the pattern that has led to the Global Financial Crisis.

C. Australia. so deleveraging today could swamp government attempts to reflate the economy. we may have been set up for a far more serious problem now. We’re very sorry. B. in Socialism. Illinois. Washington. Capitalism and Economic Growth. Bernanke At the meetings of the Eastern Economic Association. 'Some Observations On Financial Trends'. S. 2004'. M. the Greenspan-Bernanke Fed may one day justly stand accused of having caused a far greater crisis than that of 1929. we did it. most of the debt was owed by businesses—who can more easily eliminate it than can households (via reducing employment. R. under 10 per cent in Australia—so that deleveraging would have occurred from a much lower base than today’s. 1933. 'The Debt-Deflation Theory of Great Depressions'. Reserve Bank of Australia.8 per cent in Australia versus 2 per cent—so that the debt burden would have been reduced by nominal factors. S. MacMillan. Fisher. and while we have not yet fallen into deflation. and bankruptcy)—and the scourges of derivatives and securitised lending had only just begun. Battellino. 2007. Conclusion Had the Federal Reserve not intervened to rescue Wall Street from its excesses in 1987. vol. Fisher. One Banking Collapse'. 2002. Bernanke famously apologised to Friedman on behalf of the 1929 Fed. inflation is less than half the 1987 level. B.6. Bernanke. there could have been a mild Depression back then. Debt levels were comparable to 1929: 159 per cent of GDP in the USA versus 173 per cent in 1929. Finally. Today. we won’t do it again. no. But thanks to you. Reserve Bank of Australia Bulletin. Feinstein. NSW.75 per cent. DC. Chicago. Australia’s debt ratio is 2. Goodwin. 'A growth cycle'. 1969. 'The Optimum Quantity of Money'. Debtfinanced demand accounted for 23 per cent of aggregate demand at its peak in the USA. 2004. 1999.’ (Bernanke (2002)). vol. Econometrica. and deflation is already running at 0. 'The Great Moderation: Remarks by Governor Ben S. DC February 20. no. In fact. 2007. 'Remarks by Governor Ben S. terminating investment. H. thanks to Friedman’s flawed theory of money. and 73 per cent in Australia versus 64 per cent. Inflation was also higher—4. US debt is 1. Households hold more debt than business. 1967. in The Optimum Quantity of Money and Other Essays. Friedman. Cambridge. and 20 per cent here. stating that ‘Regarding the Great Depression. I.7 times as high as in 1929. Keen Household Debt -13Australian Economic Review . 1. 'Two Depressions. R. 4. and Kent. paper presented to Eastern Economic Association. and ownership of that debt has been dispersed through society via securitised lending. You’re right. October. pp 337-357. 2002. Bernanke'. ed C. 1999. pp 14-21. vol.5 times what it was in 1929. Washington. By forestalling a Depression then. November 8. paper presented to Conference to Honor Milton Friedman. in Reserve Bank of Australia Research Discussion Papers.5 per cent in the USA versus zero in 1929. University of Chicago. Debt-financed demand was a much smaller fraction of aggregate demand—13 per cent in the USA. and 7. Bernanke. Sydney. Cambridge University Press. C. Chicago.

Barnett. Centre for Policy Development. Keen. 'Unpacking the Post Keynesian Black Box: Bank Lending and the Money Supply'. of course. Keen. 16.6% is 0. 14. the impact will be felt by those who purchased the securities . 2009. M.” 3 The correlation coefficient of the total private debt ratio between mid-1993 and March 2008 to a simple exponential function with a growth rate of 4. Sussex. pp 537-556. pp 3-18. B. no. School of Economics. A. 'Finance and Economic Breakdown: Modeling Minsky's 'Financial Instability Hypothesis. H. 'Deeper in Debt: Australia's addiction to borrowed money'.. P. Armonk. Federal Reserve Bank of Minneapolis Quarterly Review. A.05% was 0. no. 2000. Journal of Post Keynesian Economics. 1995. Standing Committee On Economics. 'Bailing out the Titanic with a Thimble'. 2007. 2. 'The Endogenous Money Stock'. 17. S. A. Journal of Post Keynesian Economics. and. Canberra. 4. no. Moore. pp 3-24. 'Long Term Housing Prices in Australia and Some Economic Perspectives'. Inflation. 1 Except in Iceland. ed H. ed A. Sharpe. E. Economic Analysis & Policy.g. in Occasional Papers. O. T. H. Minsky. J. Representatives. N. and management: Proceedings of the Twelfth International Symposium in Economic Theory and Econometrics. 1. Recession and Economic Policy.. 1979. Keen. finance. vol. 1990. C. directly affect liquidity in the same fashion that a failure of bank debtors does. P.9969. P. 2007. 4. 2007. 2 In my supplementary remarks to the Wallis Committee Inquiry in 1996. no. there would obviously be a collapse in the tradeable price. Nebraska Journal of Economics and Business. Keen Household Debt -14- Australian Economic Review . pp 49-70. S. University of New South Wales. where debts (but not other nominal magnitudes such as wages) were indexed to the rate of inflation. D. 'Reference: Reserve Bank of Australia annual report 2006'.E. 1982a. and evolution: Topics in economics.. Kydland. F. 1996. potentially. Moore. Keen. no.. Minsky. 39. E. New York and Melbourne: Cambridge University Press. Stapledon. F. S. 'The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to 'Standard' Theory'. H. Wallis Committee. Journal of Post Keynesian Economics. Cambridge. the bankrupting of many of the investors. 'The Nonlinear Economics of Debt Deflation'. vol. the coefficient for the household debt ratio between 1990 and March 2008 with a growth rate of 6. S. PhD. J. Commonwealth Of Australia. pp 607-635. 2. 1. Instead. 1. Wheatsheaf. P.Keen. 5. S. B.Y. vol. marketing. complexity. 'Business Cycles: Real Facts and a Monetary Myth'.''. 1977. I anticipated that a financial crisis could result from the practice of securitised lending: “Should a substantial proportion of eligible assets (e. Canberra. Minsky. vol. no. vol. residential houses during a real estate boom like that of 87-89) be financed by securitised instruments.. vol. 'Supplementary Remarks to the Wallis Committee'. N. the inability of borrowers to pay their debts on a large scale will not.Where the securities are tradeable. pp 5-16.9966. 1982b. and Prescott. with disastrous results. in Commerce. Can "it" happen again? : essays on instability and finance. ed W. 1983.

4 In future research I will combine this model and that in Keen 2009 into a strictly monetary model of the FIH. Keen Household Debt -15- Australian Economic Review .

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